Can Bricks Beat Clicks In Groceries?

Brick-and-mortar food retailers are likely to stand their ground against new online grocery entrants because of their scale and late-mover advantages.

The future of online grocery sales is being widely debated, especially following Amazon's expansion of its home grocery delivery service to Los Angeles in June 2013. Experts are divided on the growth prospects of online grocery shopping. Fitch thinks that online grocery sales will only double or triple its current 1% market share of the $631 billion U.S. grocery market in the next decade, while Kantar Retail is more bullish and expects market share of online grocery retail to reach 4% by 2020. Let's take a look at grocers like Kroger(NYSE:KR), Safeway (NYSE:SWY), Wal-Mart(NYSE:WMT) to see if we should be bullish as well.

Scale separates bricks and clicksThere are two key reasons why it will be an uphill task for new entrants in the online grocery market to compete with the brick-and-mortar food retailers. First, the slow online adoption of online grocery shopping and the fragmented nature of the market suggest that it will be difficult for new online grocers to realize cost advantages through economies of scale. And second, the huge capital investments required for warehouses and delivery trucks, coupled with traditionally low margins in food retail, also make online grocery retail an unattractive business for newcomers.

In the end, it all boils down to scale. New online grocery players are unable to spread their fixed costs over a sufficiently large revenue base. The incumbent brick-and-mortar food retailers know that their size is their trump card, and most are expanding to meet the challenge from online players.

In July 2013, Kroger announced a proposed merger with Harris Teeter, a regional upscale grocer with stores primarily located in the southeastern and mid-Atlantic United States and the District of Columbia. Although Kroger is the largest grocer in the U.S., it is not dominant in all of its markets. According to Brian List, managing editor of trade publication Chain Store Guide, Kroger's market share is expected to at least double in places such as Virginia Beach and Raleigh, North Carolina, as a result of its merger with Harris.

It may seem counter intuitive that Safeway is going the other direction, announcing the sale of four stores in the greater Chicago area under the Dominick's banner as part of a plan to exit the Chicago market. However, this makes perfect sense when you consider that customer captivity and economies of scale for grocery retailing are local in nature. Consumers tend to be loyal customers of grocers that tailor their product assortment to local tastes and preferences. It's also worth noting that a single warehouse can only support stores within a limited geographical region, and advertising is typically most effective when it is targeted using local newspapers and television stations. Safeway is right in rationalizing its assets and focusing its attention on the West Coast, where its stores are more profitable than elsewhere.

Early mover or late mover? Among the brick-and-mortar food retailers, Safeway has made the most headway in online retail. It is now third in the U.S. online grocery space with a 3.2% market share behind pure online retailers like Peapod and FreshDirect, according to data from IBISWorld. Safeway may not benefit much from its first mover advantage, however, as it has a relatively small market share in the fragmented market.

While Kroger is not as advanced as Safeway in its e-commerce efforts, it is slowly making progress. Although Its current online grocery site HomeShop only delivers to the Colorado region, Kroger could potentially capitalize on Harris' "Click & Collect" online service. This store-based pickup model appeals to customers who prefer to see and inspect their products before final acceptance and allow brick-and-mortar food retailers like Kroger to leverage on their large store base.

The development of Wal-Mart's online grocery capabilities are at different stages, depending on which countries you are talking about. Wal-Mart boasts established store-to-home grocery delivery operations in the U.K. (Asda) and Japan (Net Super), which were started in 1998 and 2000, respectively. Meanwhile, its U.S. grocery delivery service To Go is still in beta and is currently only available in San Francisco and Denver. As a late mover in the U.S., Wal-Mart has the opportunity to study the current online grocery landscape in the US, as well as draw valuable insights from its overseas experiences. This will enable the company to avoid expensive missteps that are made by first movers and to get its business model and product offerings right.

ConclusionIt is too early to predict the death of traditional grocers. They still have an edge over their online counterparts in terms of scale and costs. Some have gotten their feet wet in the e-commerce arena already, while others are waiting for the right opportunity to ramp up their online operations in a big way. Among the brick-and-mortar food retailers, Kroger is my top pick given that it is well-positioned to capitalize on the merger with Harris Teeter to expand both its online and physical operations. In addition, it is attractively valued at 13.7 times forward P/E and 6.6 times trailing twelve months EV/EBITDA.

Author

Mark is a private value investor and is the author of CheapskateInvesting.com website which uses a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders.